Thursday, April 30, 2009

Essays on what caused the crisis

1. Barry Eichengreen feels that the problem is not so much with economic theories as such, but their "selective reading", in turn shaped by the social milieu that encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking and discourage whistle-blowing. He writes,

"It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster."

He also described twenty-first century as the age of inductive economics,
"The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.

In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time."

2. Robert Solow has an excellent review of Richard Posner's book "A Failure of Capitalism: The Crisis of '08 and the Descent into Depression". He writes that, "Panglossian ideas about free markets encouraged, on one hand, lax regulation, or no regulation, of a potentially unstable financial apparatus and, on the other, the elaboration of compensation mechanisms that positively encouraged risk-taking and short-term opportunism".

Evaluating social and environmental policies

Robert N. Stavins and Lawrence H. Goulder explain the importance and utility of the concept of discounting to evaluate the net present (or future) values (NPV) of social and environmental policies in an excellent article in Nature. Discounting helps to convert the costs and benefits from various periods into their (quantitative) equivalents at a given time, and helps policy makers choose from among a set of alternatives.

They argue that we can go ahead with the investments, if there is a potential Pareto improvement - the winners from the given policy could compensate the losers and still be better off. The problem with this approach is two-fold
1. What should be the discount rate?
2. How do we identify and quantify the present and (especially) future benefits and costs of these interventions?

But as Prof Stavins writes, "The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis). They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments."

Smart Grid and variable tariffs

President Obama's $787 bn fiscal stimulus contains significant investments in the emerging field of smart electricity grids (or more generally smart infrastructure), which uses smart meters (with computers to relay real-time the electricity consumption to the despatch center) for balancing out demand-supply imbalances. NYT has this description of an experiment by Chicago-based electricity utility, Commonwealth Edison,

"John Kieken of Manhattan, Ill., used to turn on the lights and run the washing machine, air-conditioners and other electrical appliances in his 106-year-old farmhouse whenever he wanted. At the end of the month he would get a bill from Commonwealth Edison, the big Chicago-based utility, and write a check.

Now he is in continuous conversation. He watches a Web page that gives him an estimated price for electricity at the current time, and he treats a kilowatt-hour as if it were a pound of hamburger or a shirt on a department store shelf; if it is on sale, buy now, and if not, wait. He routinely turns off an air-conditioner if the price rises too high, and if the price sinks low enough he turns off his oil furnace and heats with electricity instead... He has discovered that at odd times at night, the utility will pay him to use electricity, a quirk previously obvious only to wholesale customers."

"Dedicated" accounts to promote savings among poor

Social scientists have traditionally held the behaviour of poor people as calculated adaptations to prevailing circumstances or emanating from a unique "culture of poverty" with its psychological and attitudinal short-fallings. In contrast, behavioral economists feel that their behaviours are "neither perfectly calculating nor especially deviant". They feel that instead of major interventions, minor situational details, referred to as "channel factors", can be much more effective in addressing the problem.

In order to increase opening of bank accounts among the poor, policy makers have tried minimizing the costs of access to such accounts by opening more bank branches in villages and disadvantaged neighbourhoods, providing for no-frills accounts, streamlined account opening procedures. This has gone hand in hand with aggressive financial education and awareness campaign to overcome cultural stereotypes and misdirected attitudes.

It has been found by behavioural economists like Richard Thaler, that "contrary to standard fungibility assumptions, people compartmentalize wealth and spending into distinct budget categories, such as savings, rent, and entertainment, and into separate mental accounts, such as current income, assets, and future income. People typically show different propensities to consume from their current income (where MPC is high), current assets (where it is intermediate), and future income (where it is low)".

Accordingly, Marianne Bertrand, Sendhil Mullainathan, and Eldar Shafir recommend that rather than abstract accounts, banks or community groups could try to promote the formation of 'dedicated accounts' - a "fridge account", an "education account", or a "car account". Such labeling could be enticing and serve as a reminder of what is being saved for. In other words, they serve as a facilitative "nudge" to coax poor people to save for a specific purpose.

More relevant dedicated accounts for Self Help Groups (SHGs) in India would include those for education, health care, etc. These can be incentivized by governments making direct matching contributions, as part of a conditional cash transfer (CCT) scheme, to these specific accounts of the SHG members. In fact, a pension or health insurance scheme can be run for these SHG women by having such dedicated accounts to which the government makes pre-defined contributions.

Microfinance institutions that offer such products can tie up with retailers and suppliers offering these products and services to share the costs and minimize the prices, so as to offer the best deal. The monthly savings into the "dedicated" account will be equivalent to the EMI payments charged by the consumer goods retailer. Governments can even offer interest subvention subsidies for specific products (housing) and services (say education loans and insurance) if it so desires. This offers exciting opportunities for businesses and banks to tap the massive market at the "bottom of the pyramid", even as it opens up a channel for financial inclusion and targetted provision of welfare assistance to the poor.

Wednesday, April 29, 2009

Luck and success - the debate on raising taxes

I had blogged earlier on how initial conditions, family and societal environment, and contextual factors, all of which are the result of luck than any skill or hard work, play critical role in influencing outcomes. In his recent book, Outliers, Malcom Gladwell has demonstrated with numerous examples (Bill Gates, Beatles, Ice hockey players etc) the critical role of luck and opportunities in determining success in life. In fact, Gladwell even feels that talent is more a function of the persistance and tenacity than any inherent skill, and that skill and hard work entails dollops of luck.

Now, in the context of opposition against President Obama's decision to raise the marginal tax rates from 35% to 39.5% (by letting some of President Bush's tax cuts expire in 2010), Robert H Frank argues that there exists a very strong link between success and luck. He writes,

"Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success. It helps to be talented and hard-working, of course, yet some people enjoy spectacular success despite having neither attribute. Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. In music, even sophisticated listeners have trouble detecting differences between the handful of best cellists in the world and those in the next tier. But recording companies need only a few cellists. And if there is a discernible difference, however small, between the two groups, the best will land lucrative recording contracts while those just below them may struggle to make ends meet on an orchestra player’s salary."

Conservatives have for long claimed that the most productive people should face lower tax rates to give them strong incentives to work harder and produce more. However, Prof Frank draws attention to the staggering disparities in income and wages between those at the top and those slightly below, far out of proportion to their relative skill level and hard work, that characterises an increasing number of occupations - law, consulting, investment banking, corporate management - apart from the traditional winner-takes-all markets like sports and entertainment. He therefore rubbishes the anti-tax protesters claims that the government has no right on their incomes, earned by the dint of their hardowrk and skill.

Economists have found that random events like episodes of bad health, accidents, marital dissolutions and family emergencies play a large role in short-run year-to-year fluctuations in income, thereby eroding the credibility of the ability-alone-drives-success school. Given the substantial role played by luck in determining success and outcomes, Hal Varian has argued in favor of a model where those at the top end of the income table should pay a larger marginal tax rate so as to discount for the extra share of luck they have enjoyed. He writes, "If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky."

The luck-determines-success school, where the rich get richer and the poor get poorer, is a manifestation of the Mathew effect (Matthew 25:29, King James Version),

For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.

Tuesday, April 28, 2009

Indian electricity market modelled

In a previous post, I had explained the electricity market in India, using a parable. This post will seek to represent the market in a graphical model.

It is assumed that all distribution is done by government distribution utilities, and the sell side prices are fixed, thereby ruling out any possibility of price pass-through. Populist political compulsions mean that distribution utilities have to meet the entire demand by purchasing all the power available in the market at whatever price they are available.

Before de-regulation, the consumers are subsidized to the extent of the differential between P(cap) and P(sell). After de-regulation and the introduction of open access and trading, two things happen.

1. A significant number of generators shift their sales to the trading exchanges. The result is that the distribution utilities end up paying higher prices, varying from P(sell) to P(trade). In fact, they end up incurring an additional expenditure for the displaced quantity of power, represented by the area of FEK.

2. The few new generators, attracted by the high trading prices, invariably prefer to sell in that market. An additional quantity, represented by Qd minus Q(sup1), becomes available in the trading exchange. The distribution utility incurs an additional expenditure represented by the area of the trapezium KEIG for purchasing and distributing this power.

D curve - the end consumer demand curve
S curve - the supply curve for distribution utilities
P(cap) - price fixed by regulator for sales to consumers
P(sell) - price fixed in the long-term PPAs
P(trade) - Maximum price at which power is traded in the exchanges (when Qd is met)
Qd - Quantity of power demanded at P(cap)
Q(sup1) - quantity willing to be supplied at P (sell)
Q(sup2) - quantity willing to be supplied after trading and open access is introduced
Q(sup1) minus Q(sup2) = displacement towards trading market

Monday, April 27, 2009

A Nordic revenge!

Photographs of bankers who left Iceland after the financial crisis have a new use in the restroom of a bar in Reykjavik, the capital...

(HT: NYT via Paul Krugman)

Occupational origins of politicians

The Economist has an absolutely fascinating article on the occupational origins of politicians across the world. Two graphics from the same article, reproduced below, captures several interesting facts.

A few observations
1. Law is the dominant occupation among American politicians and engineering among Chinese apparatchiks. The dominant presence of lawyers in US, India, Brazil and Egypt may be a testimony to many complemetarities and inter-linkages between the two occupations in democratic polities.
2. The limited numbers of civil servants entering politics in vibrant democracies like India and the US, may be an indication of the fairly strong separation of responsibilities and powers between the permanent and political executives. In contrast, China, which does not have this distinction, has a large number of civil servant politicians. Though, the French establishment, with the dominance of the supe civl servant énarques, or graduates from the Ecole Nationale d’Administration (ENA), is an exception.
3. The near total absence of ex-military officials among politicians in India is a testament to its great achievement in keeping the army and uniformed forces insulated from politics. The fragile nature of South Korean democracy is evident from the disproportionately large number of military men in politics.
4. Teachers are a surprising absentee among Indian politicians. Given their large student audience and the deference given to teachers, especially in the rural context of India, one would have thought that teachers were an ideal platform for future political activity. Further, apart form lawyers, teaching is another occupation which has complementarities with politics, especially in good communication skills.
5. Business has strong presence, increasingly so in democracies like India and the US, an indication of the institutionalization of business interests in the governance system. The article lists out four possible reasons for the flight of businessmen into politics - politics helps them harm competitors; businessmen are often the only ones rich enough to finance increasingly expensive election campaigns; business people do not trust politicians to keep campaign promises and hence go into politics themselves; parliamentary immunity enables businessmen to ward off legal investigation. Businessmen are the second largest source of
6. There are also country specific exceptions among the source of politicians, like lawyers dominating in the US, engineers in China, academicians in Egypt, doctors in Brazil, civil servants and military personnel in South Korea etc.

Increasingly, though, in a welcome development, politics is emerging as a career choice. This has been made possible "by a penumbra of quasi-political institutions — think-tanks, consultancies, lobbying firms, politicians’ back offices" - all of which have increased job opportunities for would-be politicians. In India, though, it is more a career choice for the second generation in successful political families. The entry barriers continue to remain considerable for professional outsiders to make a mark.

Sunday, April 26, 2009

Regulators failed, all round

Reams have been written about who is to blame for the sub-prime mortgage crisis induced financial market meltdown and global economic recession. The villains have ranged from "greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn't see it coming, and the regulators who failed to regulate". But closer analysis reveals that it was a collective failure of all the different endogenous (risk appetite, moral hazard from various sources, agent incentive arrangements, etc) and exogenous (rating agencies, capital adequacy norms, margin requirements, etc) checks and balances, blown away by an overpowering cascade of euphoria and animal spirits.

Mark Thoma has an excellent summary (also here) of the incentive distortions and market failures that compromised the workings of the sub-prime mortgage market with such devastating consequnces, "Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on."

Fundamentally, the financial market crisis resulted from a failure to detect and even on detection, adequately deal with, a phenomenon of massive mis-allocation of liquidity into one particular sector, real estate, that generated all kinds of distortions. Policy makers and regulators, instead of blowing the whistle or "taking away the punch-bowl as the party got going", so as to put in place the appropriate course corrections, ended up fuelling the upward spiral and its excesses. And the rapid emergence of a shadow banking system, free from any regulatory oversight, unleashed ample opportunities for regulatory arbitrage.

George Akerlof and Robert Shiller have attributed this spectacular misallocation of liquidity to the power of animal spirits (the human psychology and culture at the heart of economic activity) and the waves of optimism, bordering on the suicidal, it generated. The scientific basis for this euphoria was supplied by the complex mathematical models which gave the mistaken "perception that financial innovation could produce higher rewards without increasing risk". All this in turn was under-pinned by the almost evangelical belief among the policy makers and the ruling ideologues that markets are self-correcting. The relative calm and macroeconomic stability of the era of the "Great Moderation" in the eighties and nineties had also aroused the false belief that major economic crashes are a thing of the past and the business cycle had been conquered.

In an incentives driven free market, the complex inter-play of animal spirits, with their self-fulfilling "stories that people tell to themselves - about themselves, about how others behave, and even about how the economy as a whole behaves", market failures and excesses are inevitable, necessary counterparts to innovation and efficiency. It is for the government "to set the animal spirits free and allow them to be maximally creative", by both laying down the rules of the game and then refereeing the capitalist game in the global financial markets.

However, amidst all this plethora of villains and market failures, it cannot be overlooked that most importantly, regulators at all levels were either "captured" or were a "few steps behind" or were plain incompetent. As Mark Thoma writes, "the regulators of these markets were captured by powerful forces that wanted the game to continue. The power of regulators, and the will to enforce the regulations, must match - in fact exceed - the will and power of those being regulated to resist having constraints placed on their behavior." It appears amply clear that even with blame and accusations flying in all directions, regulators have to bear the overwhelming share of the responsibility for abdicating on their duties.

What may make the whole crisis and the regulatory failure even more unpardonable is the growing belief that it was primarily the result of plain malfeasance and not the build-up of systemic risks through complex mathematical models based transactions. It has been claimed that "bad behavior was deliberately hidden behind the opaque veil of models and hard-to-pronounce financial products like collateralized debt obligations and credit derivatives. Wall Street knew about predatory lending, easy money, risky loans, overleveraged homeowners, misleading loan documents, failed business models, overleveraged hedge fund clients, shoddy ratings on Wall Street deals, and more."

This implies that regulators who were put in place to police precisely such contingencies were willing accomplices in its perpetration. It is therefore important, especially to take care of the moral hazard problems, to ensure that those responsible are investigated and brought to book. Further, there is a need to regain what Paul Krugman describes, albeit in a different context, "our moral compass, not just for the sake of our position in the world, but for the sake of our own national conscience... to investigate how that happened, and, if necessary, to prosecute those responsible."

Executive pay squeeze, you must be kidding!

The graphic below sweeps away all hopes of reductions in executive compensation amonf Wall Street firms. A review of financial staements reveals that six of the biggest banks set aside over $36 billion in the first quarter to pay their employees. And all of them have recieved tax payer bailout money.

Update 1
Andrew Leonard and Paul Krugman respond to the excesses of Wall Street in compensation payouts.

Update 2
It now emerges that the top executives in Lehman and Bear Stearns collected massive amounts in bonuses, over and above their stock options, even a year before the two disappeared.

Update 3 (7/3/2010)
The Economist has this nice graphic that captures how executive compensation bonuses for Wall Street firms rebounded nicely in 2009.

Those still in a job pocketed an average bonus of $123,850 in 2009, and a total of $20.3 billion was paid out to bankers and other securities-industry workers, 17% more than in 2008. Profits were on course to bounce back to $55 billion, after combined losses for Wall Street's finance houses of $43 billion in 2008.

Sub-prime crisis and models

Complex mathematical models that failed miserably in bringing out the risks inherent in financial transactions have been blamed as being primarily responsible for the sub-prime mortgage bubble indiced financial market meltdown.

It is in this context that two IMF economists, Heiko Hesse and Brenda González-Hermosillo, uses Markov regime-switching analysis for a variety of major global market events, and finds evidence to show that the model can detect advance signs of market turbulence emerging. Their model, which uses the VIX, TED spread, and Euro-dollar forex swap rate as proxies for global financial market conditions, indicates the movement towards high volatility state which in turn is a manifestation of systemic risk.

Euro-dollar forex swap rate
The move of the forex swap into the high volatility state on 15 September 2008 coincides with the sharp increase in counterparty risk resulting from Lehman’s failure and a sizeable dollar shortage that occurred with margins and haircuts increasing on most dollar-denominated assets.

Markov switching ARCH model of TED spread
The findings imply a regime change around the sharp Shanghai stock market correction and the first round of ABX (BBB) price declines in late February 2007, which could have been seen as a potential warning signal about the impending fragilities in the global financial system.

Markov switching ARCH model of VIX
During the Bear Stearns rescue, the VIX was more likely to be in the high rather than medium-volatility state. The Lehman failure then triggered a very fast movement of the VIX into the high-volatility regime.

Update 1
Nicholas Bloom uses models of uncertainty to forecast the impact of sub-prime crisis here and here.

Emmanuel Saez wins Clark medal

Emmanuel Saez of Berkeley wins the John Bates Clark Medal for 2009, awarded by the American Economic Association every two years (yearly from this year) to a promising young economist below the age of 40. Saez has used tax records and other information to reconstruct the long-term history of income distribution, effective tax rates, and more. Saez has written about the widening inequality in the US,

"The labor market has been creating much more inequality over the last thirty years, with the very top earners capturing a large fraction of macroeconomic productivity gains. A number of factors may help explain this increase in inequality, not only underlying technological changes but also the retreat of institutions developed during the New Deal and World War II - such as progressive tax policies, powerful unions, corporate provision of health and retirement benefits, and changing social norms regarding pay inequality. We need to decide as a society whether this increase in income inequality is efficient and acceptable and, if not, what mix of institutional reforms should be developed to counter it."

Update 1
David Warsh has this account of Saez.

Update 2
Latest, updated version of Saez-Piketty inequality tables (tables here) show that US inequality continues on its inexorable upward trend. It shows that from 2006 to 2007, while average real income per family grew by a solid 3.7%, the same for the top percentile grew faster at a rate of 6.8%, further increasing the top percentile income share from 22.8 to 23.5%, the highest recorded share for them since 1928.

Update 3 (6/3/2012)

Emmanuel Saez and Thomas Piketty have their latest income share graphic, updated for 2011,

They write,

This suggests that the Great Recession will only depress top income shares temporarily and will not undo any of the dramatic increase in top income shares that has taken place since the 1970s. Indeed, excluding realized capital gains, the top decile share in 2010 is equal to 46.3%, higher than in 2007...

Saturday, April 25, 2009

Stress test results

The much awaited stress results, not publicly announced but shared privately with the 19 banks that underwent the tests, have turned out to a damp squib as expected. The Fed announced that though the banks had enough capital to offset a raft of new losses, it would still need a new cushion of financing on top of the current minimum levels as a buffer against higher losses if the economy worsened. This strengthens the widely held belief that the government would support the largest banks even if their financial health eroded and that the banks may be forced to dilute their common stock in exchange for further equity infusions from the government.

There are also indications that the events till date may have widened the gap between the stronger set of banks led by the major investment and custodial banks like Goldman, Morgan Stanley, JP Morgan Chase, US Bancorp etc and the embattled majors like Citigroup, Bank of America, and Wells Fargo and the regional banks. However, the financial sleight of hand that dressed up the better than expected last quarter results among some of the banking majors, means that even those perceived as being better positioned may only be illusory.

The Fed also released the details of the parameters used in the stress tests, available here (and here).

More comparison of US recessions

Floyd Norris draws attention to the Index of Coincident Indicators, compiled every month from official US government data, which indicates that the current recession has become the second-worst in the last half-century and is close to surpassing the severe 1973-75 downturn. The figure for March, released this week, showed a decline of 5.6% from the high set in November 2007, the month before the recession officially began in the US. The index is constructed from four indicators - unemployment, personal income, industrial production and manufacturing and trade sales.

Education bang for the buck

From the Program for International Student Assessment (PISA) report, comes the graphic below, which captures the cost effectiveness of spending on school education across the world. Since, India was not part of the PISA survey, its figures are unavailable.

(HT: McKinsey report on schooling in US, via Economix)

Friday, April 24, 2009

End of decoupling?

From the IMF's World Economic Outlook 2009 (full report here),
"In addition to its severity, this global recession also qualifies as the most synchronized [downturn in the postwar period], as virtually all the advanced economies and many emerging and developing economies are in recession."

(HT: Economix)

Nudging on car loan repayment!

Ian Ayres, via AOL Autos, draws attention to an article on a technology being used by some sub-prime auto loan issuers in the US, that provides for shutting off the engine if you default on payment of the loan instalment. Such devices are an excellent example of commitment contracts that nudge borrowers to making prompt payments.

The device, a product of telematics revolution (that blends telecommunications and wireless technologies), is controlled remotely by the dealer or lender and linked to the vehicle's powertrain. Before the deadline, the driver is treated to a concert of tones and flashing indicators signaling that the deadline is approaching. There are also warnings after the deadline has passed. Its proponents say the device is a win-win arrangement for everyone - dealers can sell cars to people who would have a hard time getting a loan otherwise, and buyers end up paying a somewhat lower interest rate because the risk to the lender is less. Further, the GPS device in the vehicle to facilitate re-possession, can double up as an anti-theft measure.

Where are the entreprenuers in electricity distribution?

Technology intensive sectors presents unique opportunities for upcoming entrepreneurs. The success or otherwise of these entrepreneurs depends on their ability to spot opportunities, tailor a product or service, successfully demonstrate its utility and superiority (over rivals), and then use it to vault into the larger market. There are no scarcity of opportunities and there are also large numbers of competing new and untested products, especially in technology related sectors. But the biggest challenge for entrepreneurs is in successfully demonstrating its product by using the platform of one of its larger clinets for such services/products.

In electricity distribution, the scope for such innovations is immense - simple and automatic metering, meter readings and billing solutions, collections channels, data communication technologies, sub-station devices and equipments, distribution transformers, energy audit and other application softwares etc. Over the past year, I have personally witnessed presentations by numerous entrepreneurs on new and innovative products and services, many of which would undoubtedly add considerable value to the distribution utility and increase revenues and reduce losses.

Since all these are untested products, it is understandable that the distribution utility would be wary of its functional effectiveness and therefore expect the entrepreneur to bear the associated risks. The platform and opportunity offered by the distribution utility to the entrepreneur in testing out and perfecting its product, would in any market command a price. The product offers different attractions for the utility and its seller. The utility benefits by way of the possibility (not certainty) of a new product improving its functional efficiency, whereas the entrepreneur benefits by way of an opportunity to perfect and a platform to demonstrate (effectively get a certification) his new product, and thereby get a head start in an emerging market.

In fairness, the entrepreneur can expect the utility to pay the actual costs incurred in assembling the product, minus the sunk costs incurred in developing it and the oportunity cost of the entrepreneur's time. It may also be fair to have an arrangement where the entrepeneur gets compensated with a "success fee" on the successful demonstration of the product. But it may be unreasonable to expect the utility to pay its portion of the sunk costs and entrepreneur's time reward on a a product whose utility is not proven. This distinction assumes significance, especially in the context of such sectors, with numerous such new products proliferating in the market.

Unfortunately, my experience with such "entrepreneurs" seeking entry into the electricity distribution sector, has been disappointing, with most (if not all) of them expecting the utility to bear their risks and pay an unreasonably high price for the product, including sunk costs and entrepreneur opportunity cost. Even incentivization by way of deferred "success fee" on successful demonstration has not managed to cut much ice with them. And APEPDCL has traditionally been one of the most fertile gorunds for catalysing innovations in electricity distribution sector!

Home price indicators

Casey Mulligan draws on BEA data to demonstrate how the recession and the end of the wealth effect from the popping of asset bubbles may have left a huge demand-supply gap in housing stock in the US.

And The Economist has this index of home price indicators.

Thursday, April 23, 2009

Talk about ironies...

... this quote from eminent journalist and one of the finest chroniclers of "poverty in India", Mr P Sainath, stands out,

"While the Lakme Fashion Week, 2006, was on, farmers were committing suicide in Vidarbha, Maharashtra, to the tune of seven a day. Yet, there were all of six journalists covering Vidarbha in the mainstream press, while ther were 512 covering the Fashion Week. The theme of the fashion week was cotton; yet within that time frame, nearly 50 cotton farmers had killed themselves."

IMF on the world economy

The IMF's latest World Economic Outlook (WEO) (summary abstract here) has projected the most severe global recession since World War II, with the global economy set to shrink by 1.3% in 2009, compared to the 3.2% growth in 2008. It however claims that the economy would be back on the recovery path as the rate of contraction should moderate from the second quarter of 2009 onward, and estimates growth for 2010 at 1.9%.

The advanced economies are projected to contract by 3.8% in 2009 and by 2.8% and zero growth in 2010, emerging economies to grow by 1.6% and 4%, and Africa by 2% and 3.9% respectively. The IMF has revised the Indian growth projections downward to 4.5% and 5.6% for the next two years.

The WEO also estimates that unemployment will crest only toward the end of 2010, and should decrease after that. It advocates bold efforts to heal the financial sector and aggressive macroeconomic policies, both fiscal and monetary, to boost aggregate demand and "minimize the corrosive feedback from weakening real economic activity on the financial sector".

The IMF has estimated the total financial market losses from the sub-prime crisis to be $4.1 trillion, of which $2.7 trillion is from loans and assets originating in the United States, up from $2.2 trillion in the fund’s interim report in January, and $1.4 trillion last October.

The WEO also claims that emerging economies are now so closely integrated with advanced economies that financial stress transmits rapidly and forcefully, with financial linkages a key channel of transmission.

Calling for greater global financial market and economic surveillance, including tracking systemic linkages, the WEO report advocates taking action to prevent financial institutions becoming too interconnected and too big to cause serious collateral damage on the rest of the market. The report finds that markets that operated virtually or totally independently before the subprime crisis began to move together afterward, evidence that new channels of liquidity shocks were established during the second half of 2007.

Wednesday, April 22, 2009

Discrimination and the economics of life

Here are five examples that illustrate the importance of initial conditions, family and societal environment, and contextual factors in influencing outcomes in unexpected manners.

1. Edgar Johns of JobApp Network, a firm that helps other companies hire, has done an interesting study of over 25,000 applicants to restaurant and retail job positions. Of those job seekers applying by phone, more than 40% were minorities. When it came to applying over the web, the share of minorities fell to less than 20%. His conclusion: as firms move more and more toward taking only online applications, there could be an adverse impact on minority applicants.

He writes, "Employers who offer only a web-based employment application process limit their applicant pool and may also adversely impact their efforts to promote diversity. In the worst case, it may unwittingly contribute to discrimination in hiring. Fortunately, low-cost and highly effective automated hiring solutions incorporating both the phone and the web enable employers to avoid these pitfalls without investing in hiring kiosks or devices."

(HT: Freakonomics)

2. Sendhil Mullainathan and Marianne Bertrand, found that applicants named Lakisha or Jamal were less likely to be considered for jobs, even when they had qualifications on paper that were similar to those of applicants named Emily or Greg. They conducted an experiment using fictitous resumes on job placement ads in Boston and Chicago, with each resume assigned either a very African American sounding name or a very White sounding name so as to manipulate race perceptions. They found that white names received 50% more callbacks for interviews. Further, it was also found that race affects the benefits of a better resume, with a higher quality resume eliciting a 30% more callbacks for white names, against a much smaller increase for African-American names. Applicants living in better neighborhoods receive more callbacks but, interestingly, this effect does not differ by race.

They found that the amount of discrimination is uniform across occupations and industries, with even the federal contractors and employers who list Equal Opportunity Employer' in their ad discriminating as much as other employers. All these conclusively point to the salience of racial discrimination in the hiring decisions of employers in the labour markets. More evidence of such labour market discrimination is available in the NBER working papers here.

3. Alan Krueger surveys the emerging literature on intergenerational transmission of economic status and writes that it is becomingly increasingly apparent the "secret to success is to have a successful parent". Bhashkar Mazumder and David I. Levine studied the correlation in earnings, family income and wages between brothers from 1970s to 1990s and conclude that family and community influences shared by siblings have become increasingly important in determining economic outcomes.

Research by Mark Huggett, Gustavo Ventura and Amir Yaron finds that from the age of 20, differences in initial conditions account for more of the variation in lifetime utility and in lifetime wealth than do differences in shocks received over the lifetime. Among initial conditions, variation in initial human capital is relatively more important than variation in learning ability for determining how an agent fares in life.

4. Anne Case, Angela Fertig, and Christina Paxson compare data from a birth cohort that has been followed from birth into middle age, and find that "controlling for parental income, education and social class, children who experience poor health have significantly lower educational attainment, poorer health, and lower social status as adults". They find that childhood health and circumstance appear to operate both through their impact on initial adult health and economic status, and through a continuing direct effect of prenatal and childhood health in middle age.

Cohort members born into poorer families experienced poorer childhood health, lower investments in human capital and poorer health in early adulthood, all of which are associated with lower earnings in middle age — the years in which they themselves become parents.

5. Resul Cesur and Inas Rashad find that children with a high birthweight (over 4.5kg) (like children with low birth weight too) score worse on maths and reading tests age six than those with average birthweight, a result which holds even controlling for family income among other things. This assumes significance in the light of recent findings that cognitive skills even at a young age are correlated with an ability to do well at school and thus with earnings in later life.

Update 1 (15/4/2011)

Daniel Hamermesh and Jason Abrevaya writes,

We measure the impact of individuals’ looks on their life satisfaction or happiness using various sets of data from the US, Canada, the U.K., and Germany. The results show that:
1. Personal beauty raises happiness.
2. The majority of this positive effect comes about because personal beauty improves economic outcomes – incomes, marriage prospects, and others – that increase happiness. Thus much of the positive effect of beauty on happiness is indirect – through its effects on aspects of economic life that increase happiness.
3. The total effects of beauty on happiness are about the same for men and women. But the direct effect is larger among women – beauty affects their happiness independent of its impact on their incomes, marriage prospects, and other outcomes.
Because the beauty measures are collected in a variety of ways, and because happiness is also measured in various ways, we can be quite confident in the general validity of the conclusions.
Update 2 (28/3/2012)

A working paper by researchers examining evidence of discrimination based on physical appearance in donations made through Kiva has more evidence of such discrimination. They write,

We find that donors appear to discriminate in favor of more attractive, lighter-skinned, and less obese borrowers, even as donors appear to systematically favor regions of the world where lighter skin is less prevalent. These effects are statistically and quantitatively significant and robust across a variety of specifications. Discrimination on the basis of physical attraction and skin color appears to be heightened for female borrowers, while obesity matters more for male borrowers.

Central Banking in democracies

Through Mostly Economics, an excellent speech by Alan Blinder, on Central Banking in a democracy.

In an indication of how much times have changed, he says, "The story is told that the only way President Kennedy could remember the difference between monetary policy and fiscal policy was that the letter 'M' for monetary was also the first letter of the name of the Fed Chairman at that time, William McChesney Martin".

The Federal Reserve Act has directed the Fed to promote "maximum employment, stable prices, and moderate long-term interest rates". It is effectively a "dual mandate" - full employment and price stability. Interest rates influence investment decisions in the short run, and such decisions in turn affect employment and unemployment in the medium term. "The lag from monetary policy decisions to inflation is even longer than the lag from monetary policy to employment because monetary policy first has to affect spending, and then spending must affect inflation." Prof Blinder feels that the lag between monetary policy decisions and impact on inflation to be about two years. He captures the central dilemma for Central Bankers thus,
"Unless inflation is below the Federal Reserve’s long-run target, which hasn’t been true in a very long time, there is a short-run trade-off between the two goals — maximum employment and stable prices — that are set forth in the Federal Reserve Act. To push inflation lower, the Fed must make interest rates high enough to hold total spending below the economy’s capacity to produce. But if it does that, the Federal Reserve will be reducing employment, contrary to the dictum to pursue 'maximum employment'. So monetary policy is forced to strike a delicate balance between the two goals... (However) while there is a short-run trade-off between inflation and unemployment, there is no long-run trade-off."

As Keynes said, modern industrial economies are not sufficiently self-regulating - total spending sometimes roars ahead of productive capacity, which leads to accelerating inflation, and sometimes lags behind productive capacity, leading to unemployment. But, about what actually happens, Prof Blinder says,

"In principle, either fiscal policy—the government’s taxing and spending policy—or monetary policy could serve as the balance wheel, propping up demand when it would otherwise sag and restraining it when it threatens to race ahead too rapidly. In practice, however, monetary policy is the only game in town nowadays. The reason... The need to reduce large fiscal deficits dictates that budget policy remain a drag on total spending for the foreseeable future, regardless of the state of the macroeconomy. With the fiscal arm of stabilization policy thereby paralyzed, a central bank that decides to concentrate exclusively on price stability is, in effect, throwing in the towel on unemployment."

So Prof Blinder's prescription,

"A central bank could do its part to achieve low unemployment by pushing the nation’s total spending up to the level of capacity, but not further".

About the independence of Central Banks, he says two things,

"In a democracy it seems not just appropriate, but virtually obligatory, that the political authorities should set the goals and then instruct - and I use that verb advisedly — the central bank to pursue them. If it is to be independent, the bank must have a great deal of discretion over how to use its instruments in pursuit of its assigned objectives. But it does not have to have the authority to set the goals by itself.

The second critical aspect of independence, in my view, is that the central bank’s decisions cannot be countermanded by any other branch of government, except under extreme circumstances. Without that immunity, the Fed would not really be independent, for its decisions would stand only as long as they did not displease someone more powerful."

About why countries with independent Central Banks have enjoyed superior macroeconomic performance, apart from the short-time horizon perspectives of the political executive and the need for professionalism, he writes,

"You pay the costs of disinflation up front, and you reap the benefits—lower inflation—only gradually through time. So, if politicians were to make monetary policy on a day-to-day basis, they would be sorely tempted to reach for short-term gains at the expense of the future—that is, to inflate too much. Aware of this temptation, many governments wisely depoliticize monetary policy by delegating authority to unelected technocrats with long terms of office, thick insulation from the hurly-burly of politics, and explicit instructions to fight inflation."

Tuesday, April 21, 2009

Grow rich to go green!

NYT has a nice summary of the Environmental Kuznets Theory school of environment and economic growth that debunks the conventional "limits to growth" theories (as countries develop, they use more resources, degrade the environment more, and thereby the ongoing phase of global economic development, especially that of the emerging economies, is unsustainable) and argues that "the richer everyone gets, the greener the planet will be in the long run". The Kuznets graph is shown below.

Each line is an environmental Kuznets curve for a group of countries during the 1980s. The levels of sulphur dioxide pollution (the vertical axis) rise as countries becomes more affluent (the horizontal axis). But then, once countries reach an economic turning point (a gross domestic product close to $8,000 per capita), the trend reverses and air pollution declines as countries get richer. In this analysis by Xiang Dong Qin of Clemson University, the green line shows countries with strong protections for property rights; the red curve shows countries with weaker protections.

In the early nineties, Gene Grossman and Alan Krueger had made the path breaking finding that economic growth does not result in deterioration of environment quality, and that it only brings an initial phase of deterioration followed by subsequent phase of improvement.

Bruce Yandle, Madhusudan Bhattarai, and Maya Vijayaraghavan (full paper here) explored the Grossman-Krueger and other studies to argue that apart from rising incomes, improvement of the environment also depends on government policies, social institutions, and the completeness and functioning of markets. They write, "Because market forces will ultimately determine the price of environmental quality, policies that allow market forces to operate are expected to be unambiguously positive. The search for meaningful environmental protection is a search for ways to enhance property rights and markets."

Jesse Ausubel and Paul Waggoner have examined the effect of economic slumps on energy use and emissions in the US and have found little evidence of any ong term shifts induced by those episodes. It therefore would appear that economic growth, markets, and appropriate institutional and regulatory frameworks are all essential components in the campaign to improve environmental quality. And, faster the developing economies grow, earlier will this transition happen.

Power generation in India

For all high-profile talk of Ultra Mega Power Plants (UMPP) and private participation in generation capcity addition, the private sector makes up less than 20% of the proposed capacity addition for the Eleventh Plan period (2007-12). In fact, NTPC alone, with a proposed capacity addition of 22,000 MW is set to add more than the entire private sector.

Interestingly, the private footprint on the power generation space is even limited, at less than 15% of the total capcity. Of this too, nearly half is in the renewable energy space, where private investments have been incentivized by heavy government subsidies. But this space is dominated by fragmented investments in small projects.

For sometime now, as seen by the focus on private participation in infrastructure through Public Private Partnerships (PPPs) etc, policy makers and sector specialists have been spreading the belief that private sector can play the critical role in many sectors like telecommunications, power, ports, airports and roads. Power generation had been thought of as providing attractive investment opportunities for private players, and accordingly Planning Commission have been tailoring policies to accomodate a prominent role for them. However, even recent track record and projects in the pipeline would appear to indicate that this hope may be misplaced, and their role will remain marginal for the foreseeable future.

Even including public sector, the general performance in capacity addition in generation has been dismal and continues to be so. A mere 21,180 MW of capacity was added over the Tenth Plan (2002-2007), and it is now clear that the Eleventh Plan achievement too appears certain to fall short by 50-60%. In the first 20 months of the Eleventh Plan, only 11,936 MW or 44% of planned target for this period.

As Businessline reports, challenges in implementation range from operational issues such as equipment delays, fuel delays owing to non-availability of escrow accounts, and funding delays.

The planned capacity in the present Plan would require a total outlay of Rs 4.1 lakh crore for power generation alone, and at a 70:30 debt-equity ratio, Rs 1,23,000 crore of equity needs to be raised. These are not easy to raise given the weak equity markets and declining profits and other internal accruals. For the debt portion, the liquidity crunch has closed some of the avenues available, particularly the ECB route. For projects based on power purchase agreements, the two-part tariff will help pass through the higher interest cost to the consumers. But fixed tariff projects, such as the UMPPs, may face pressures arising from higher financing costs.

Raising revenues during hard times

With property tax revenues declining and capital becoming costlier, the NYT reports that cities across the US are resorting to user charges and other unconventional fees to raise revenues to bridge their budgetary deficits. Since raising taxes is not an option and fees are more palatable than taxes, local governments have found innovative ways to raise resources - charges to clean up vehicle crashes on at-fault drivers, higher fees to renew licenses and for fresh registrations, "streetlight user fees", higher parking and other user fees, more intensive penalizing drives and higher fines by policemen and other enforcement agencies etc.

Monday, April 20, 2009

Forwards and options in sports tickets

With IPL underway, one of the biggest problem for respective city fans would be over the procurement of tickets for the latter matches and final stages, given the natural uncertainty surrounding the prospects of their teams and the fact that tickets are sold out well in advance. It may not offer much attraction for a Kolkota Knightriders fan to go all the way to South Africa to watch a final between Chennai Super Kings and delhi Daredevils. In such circumstances, the fans are left with only two alternatives - buy the ticket in advance and risk not using it or buy it at exorbitant rates in the blackmarket (or from scalpers) after their teams entry is confirmed.

Given the success of options and forwards contracts in financial markets in hedging for similar uncertainties, one would have though that it would be natural for an options market to develop around ticket sales for major sporting events. Traders hedge for the uncertainty in the movement of share prices by taking short (sell at a strike price) and long (buy at a strike price) positions through options and forward contracts. IPL and other major sporting event organizers can take a leaf out of the financial markets and create a market in forwards and options contracts in tickets to both reduce scalping and make fans happier.

Felix Salmon and Alvin Roth draw attention to the work of Preethika Sainam, Sridhar Balasubramanian, and Barry Bayus who examined ticket pricing in sports markets where there is uncertainty about the teams that will play in a final event, and proposed an options market in ticket sales. They also claim that a model where fans can buy an option on a ticket well before the event and then decide on exercising the option, is not only beneficial to fans, but also more profitable for the organizers. In fact, the authors find that a ticket options model brings in greater profits for the organizers than both advance ticket sales and sales after the uncertainty is resolved.

Al Roth feels that the better alternative would be to "replace some (but not all) of the tickets with team-specific forwards, which expire worthless if that team doesn’t make the finals", thereby allowing the 'team-oriented' fans to "buy forwards rather than tickets which they might not want if their team fails to make it to the finals". With options prices going up as the event deadline approaches, scalpers would find it profitable to trade the tickets procured by them in the options or forwards markets, thereby driving ticket sales in the black to the margins and eventually eliminate them.

There are important market design details (which are event and sport specific) to be worked out before this can be operationalized for sports events - number of ticket options to be sold, pricing of the options etc. The success of such models would depend on the thickness of the market, or the numbers of tickets that are available for trading. The model may therefore be more approapriate for very big events, where the attendance runs into a few tens of thousands.

Felix Salmon advocates taking it a step forward and suggests that hotel owners, instead of selling their rooms only once, can adopt the model by selling room reservation options that expire if their team does not make it to the finals. They stand to gain much more since, irrespective of anything, last minute demand for hotel rooms would persist during large events.

Whatever the final design of the market, I would not be surprised if some sporting event organizers soon adopt this model to market their tickets. And with financial markets imploding, laying off many financial sector professionals and drying up markets and profit opportunities, sporting event ticket options and forwards offers an excellent and much needed emerging opportunity for them and the economy!

Update 1
Miley Cyrus has decided to offer only e-tickets and deploy other innovative antiscalping technologies at each venue in her tour through 45 cities to control scalpers.

Stress test charade?

The NYT reports that after labouring through records of nineteen of the largest banks for the past eight weeks in the name of "stress tests" under the Geithner Plan, nearly 200 federal examiners appear to have come to an interesting conclusion - the banks are in a better shape than what everyone thinks, but despite all the bailout money pumped in, they will still need further bailing out! This raises the question - if all the banks have passed the stress tests, but will still need to be bailed out, then what was the purpose of these tests?

The tests, led by the Federal Reserve, rely on a series of computer-generated "what-if" projections in the event the economy deteriorates, so as to judge all the financial institutions against a common set of standards. Those include unemployment rising to 10.3% by next year, home prices falling an additional 22% this year, and the economy contracting by 3.3% this year and staying flat in 2010. Critics have questioned these standards as all being too optimistic. As part of the tests, the banks analyzed each category of loans they held and compared their results with the "high" and "low" range of government loss estimates. The banks were also asked to project their earnings over the next two years to give the regulators a better sense of how much capital they would have to absorb the coming losses.

Since the tests are being conducted outside public view with little or no disclosure, there are serious dounts being expressed about the rigour of these tests. The credibility of stress tests will be open to question if all those exposed to it pass the test. The Geithner Plan had hoped that the stress tests would provide a "seal of good book-keeping" to bridge the information asymmetry and encourage investors to lend to stronger banks, thereby enabling them to raise capital for their regular activities and in the process unfreeze the deadlocked credit markets.

Naked Capitalism has this scathing indictment of the stress tests, describing them as a "charade" and a "complete sham". In the absence of transparency about the stress test details and the controversy surrounding the use of tangible common equity as the measure of capital adequacy ratio, some others have called the TARP stress tests asinine.

The Geithner Treaury will argue that these tests give the government adequate information to assess the extent of problems and formulate specific bailout plans for each institution, instead throwing money into dark holes, as was hitherto being done.

Sunday, April 19, 2009

Synthesis emerges - time for Obamanomics?

For the thesis in free-market capitalism and the anti-thesis in command economy socialism, there have been many attempts at the Hegelian synthesis, most famously in mainland Europe's social democratic capitalism and more recently in the Blairite Third Way movement. With unbridled free-market, limited government, American style capitalism crumbling in the face of the worst economic crisis since the Great Depression, the search for alternatives has intensified.

It is in this context that Barack Obama has weighed in with his version to reshape American capitalism - Obamanomics. It seeks to reduce consumerism and encourage savings and investment ("move from an era of borrow and spend to an era of save and invest"); redistribute wealth towards the middle class; make rest of the world less dependent on the US market for their growth; markets are not self-correcting and are vulnerable to market failures; and a recongnition that an activist government is an acceptable and necessary partner for a stable, market-based economy. His advocacy is for a more healthy and sustainable expansion of the economy, with more widely shared benefits and free from the macroeconomic imbalances and distortions that marked growth over the past two decades, and where people are far less exposed to the vicissitudes of a market economy.

While accepting the fundamental tenets of free-market capitalism about the power of markets as an engine of innovation and prosperity, and the necessity of economic growth for improving incomes and living standards, it clearly breaks with the Reaganite tradition that viewed government as part of the problem and not solution. The challenge for Obama would remain in implementing this ambitious center-left (or center-right) agenda.

Dream and feel good...

... this YouTube video on Susan Boyle, a contestant in the "Britain's Got Talent" music show, has been watched and raved over by more than 30 million and counting...

Also read this, this, and this, and see this video.

Update 1
Chris Dillow on the economics of Susan Boyle - statistical prejudice, contrast effect etc

Pop the Summers' "brain bubble"!

Naomi Klein makes this scathing indictment of Lawrence Summers, and advocates banning him from public life. Describing him as an example of the "Brain Bubble", "wherein the intelligence of an inarguably intelligent person is inflated and valued beyond all reason, creating a dangerous accumulation of unhedged risk", she writes,

Brain Bubbles start with an innocuous "whiz kid" moniker in undergrad, which later escalates to "wunderkind." Next comes the requisite foray as an economic adviser to a small crisis-wracked country, where the kid is declared a "savior." By 30, our Bubble Boy is tenured and officially a "genius." By 40, he's a "guru," by 50 an "oracle." After a few drinks: "messiah."

... he has been spectacularly wrong again and again. He was wrong about not regulating derivatives. Wrong when he helped kill Depression-era banking laws, turning banks into too-big-to-fail welfare monsters. And as he helps devise ever more complex tricks and spends ever more taxpayer dollars to keep the financial casino running, he remains wrong today. Word is that Summers's current post may be a pit stop on the way to the big prize, Federal Reserve chairman. That means he could actually make "maestro."

Recession and foodgrain prices

Over the past year, global foodgrain prices have had a yo-yo run, touching a peak and then declining dramatically as the economy spiralled into a recession. Expressed in US dollars per metric tonne, the prices of rice fell from its May 2008 peak by 59%; maize fell 43% from its June 2008 peak; soybean fell 77% from its July 2008 peak; wheat fell from its February 2008 peak by 53%; and oil prices have also declined by about 65% from July 2008 peak. But when compared with their historical averages, global grain prices today remain way above their ten year averages - rice by 49%, maize by 43%, soybean by 36% and wheat by 31%.

Pedro Conceição and Ronald U. Mendoza argue in a Vox article that despite the decline in global foodgrain prices, domestic food prices in many developing countries have remained "sticky". And falling household incomes due to the economic slowdown has magnified the impact of the high prices. It also finds that many of the supply constraints that contributed to the high prices - biofuel policies, low global stocks, thin trading in foodgrains, and lack of investments in agriculture - continue to remain unresolved, and ready to erupt anytime.

Tim Harford explains Schelling's chessboard experiment

Tim Harford has this excellent description of Thomas Schelling's chessboard experiment that sought to explain how hetergenous groups or societies invariably end up segregating among themselves.

I have blogged on this phenomenon in the context of racial segregation based on school neighbourhoods here and here.

Saturday, April 18, 2009

CDS Vs gambling - need for an "insurable" interest?

William Buiter draws an important distinction between using derivatives for insurance (and risk management) and for gambling, and explains why the latter is "harmful finance", and therefore needs to be regulated. He writes,

"Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain). CDS can provide either insurance against loss or an opportunity to gamble. This (gambling) is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure. The buyer does not have to suffer any loss from the default event and may in fact benefit from it.

When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs, you are not better off than you would be if the insured-against future contingency did not occur.

Clearly, CDS contracts don’t require an insurable interest to be present. Many other derivatives likewise don’t require an insurable interest to be present. Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest."

Buiter therefore outlines six reasons why like gambling, "naked" position in CDS (which do not have an underlying insurable interest) should be discouraged or banned

1. Gambling is addictive

2. Moral hazard or micro-level endogenous risk - "if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency. It’s also likely to be an illegal form of market manipulation."

3. Derivative contracts as "bearer lottery tickets" - unlike most conventional lotteries, the lottery tickets created (by the writer in the ‘primary issue market’) as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges. The owners of these bearer securities are anonymous, and ownership is not registered and hence unregulated. There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed.

4. Risk-seeking by the over-confident
Most of the derivatives trading are among financial intermediaries, mainly among different banking or shadow-banking player, and are driven by overconfidence and hubris about "beating the market" among traders. Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves, and "the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it - those most confident of being able to bear it and profit from it".

5. Churning -
Given the huge reliance on endogenous variables, derivatives trading is not costless. Scarce skilled resources are diverted to what are not even games of pure redistribution, but "games involving the redistribution of a social pie that shrinks as more players enter the game". This also affects the real economy by way of an increase in the severity and scope of defaults, which in turn involves more than a redistribution of property rights (both income and control rights). They also destroy real resources, thereby generating a negative-sum redistribution. The easiest solution to this churning problem would be to restrict derivatives trading to insurance, and the party purchasing the insurance should be able to demonstrate an insurable interest. CDS could only be bought and sold in combination with a matching amount of the underlying security.

6. Macro-endogenous risk

Financial markets being inefficient in many ways, "the distinction between fundamental, exogenous variables and endogenous variables disappears and CDS prices can become quasi-autonomous drivers of the bond prices. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on spot markets and real production, consumption and storage decisions."

Update 1
Andrew Leonard makes the interesting point that CDS generates moral hazard in other ways too by making the buyer of CDS less willing to cut a deal that would allow its underlying security issuer to avoid bankruptcy, because he can get paid in full in the event of that bankruptcy by collecting on the insurance policy.

Update 2 (29/5/2010)
Uwe Reinhardt has this excellent primer on naked CDS and short sales. In case of naked short sales, the short-seller borrows the security only after the sale. Although in principle the shares must be delivered to the buyer within a specified time (three days under American law), in practice that stricture often is observed in the breach. Naked short-selling is controversial, because without the constraint of actually having the security in hand, short-sellers can dump a huge volume of a security onto the market in a so-called "bear raid", depressing the security’s price in a self-fulfilling prophecy.

Similarly, a CDS sold to someone who does not own the underlying debt instrument (the “reference bond”) is called a naked CDS. In fact, one does not need to own a particular debt instrument to purchase credit-default-swap protection on it. Indeed, one does not even need to know who owns the bond. Because the spreads on a particular debt instrument change over time, one can profit (or lose) by trading swaps. Currently, the market for them is comprised predominantly of naked swaps, because multiple ones can be sold on a particular debt instrument.

CDS are a form of insurance under which the seller agrees to protect the buyer against default on an underlying debt instrument, in return for which the buyer pays the seller quarterly or semiannual premiums expressed in basis points (one percentage point being 100 basis points) per year of the amount of the debt (the "notional") being so protected. This premium is also called the "CDS spread".

China and US deficits

It is estimated that more than two-thirds of the Chinese Central Bank’s $1.95 trillion in foreign exchange reserves are believed to be in American securities, with the rest in assets denominated in euros, yen and other currencies. Some other estimates puts its holdings of the US debt papers at $1.7 trillion. But recent trends indicate that these purchases, which have for so long financed the massive US current account deficits, besides contributing to keeping the US Dollar strong, may be waning.

Brad Setser, though, feels that instead of declining, the accumulation of foreign holdings may have stabilized.

It is now well acknowledged that the macroeconomic imbalances generated over the past two decades in the world economy, by way of the currency manipulation by Central Banks, "savings glut" and exports generated foreign exchange reserves of emerging economies and the consumption driven imports surge in the US fuelled by the "wealth effect" unleashed by successive asset bubbles, has been a major contributor to the ongoing economic crisis.

After the crisis broke out, the spectacularly swift de-leveraging of their positions in emerging economies by the Wall Street firms and the flight to the relative safety and liquidity of US dollar denominated assets by private investors across the world have had the effect of shoring up the beleaguered dollar, sustaining the huge US current account deficits, and keeping interest rates low.